Technical traders use the Moving Average Convergence Divergence (MACD) indicator to identify trends and momentums. The MACD and price trends can be a powerful tool to determine whether a stock is building momentum, headed for a possible reversal in trend. Like all technical indicators, it doesn’t work all the time, but it is successful enough that it is a staple for many traders.
Moving Average Convergence Divergence in action
Before looking at an example, let’s quickly cover the basics on this indicator. The Moving Average Convergence Divergence indicator generally uses the 12-period exponential moving average (EMA) and the 26-period EMA, and the indicator is calculated by subtracting the 26-period EMA from the 12-period EMA. After getting the results of this calculation, a nine-period EMA of the moving average convergence divergence is plotted. This nine-period EMA of the MACD is known as the signal line.
The MACD can show bullish or bearish divergence. A bullish divergence occurs when the MACD is making higher highs, while the stock price is making lower highs.
Let’s take a look at an example of a bullish divergence.
In this daily chart on NVIDIA Corp. (NVDA), notice how NVDA was making lower highs, but found some support around the $96 area. Looking at the MACD, as annotated, the indicator is making higher lows and higher highs. This is considered a bullish divergence, and an indication that the stock could reverse. You can see for yourself how that trade would have worked out, if you went long based off of this pattern.
As traders, we must always do our homework. Go out and find stocks that exhibit bullish and bearish divergences. For the bearish divergence, look for higher highs in price action, and lower highs in the MACD; the opposite is true for bullish divergence. Again, this pattern doesn’t always work out as expected, so manage your risk properly and get out if there is no visible confirmation of the signal you spot in the charts.
Jason Bond runs JasonBondTraining.com and is a swing trader of small-cap stocks.
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